DeMarco argues that debt forgiveness goes beyond his
authority and would result in untenable losses for the mortgage
giants. This is a curious position given that he is a
presidential appointee and everyone from President Barack Obama
to lawmakers to Federal Reserve Chairman Ben S. Bernanke has
called on him to go ahead and do it. Economists and housing
analysts say debt relief is essential to preventing a death
spiral in which rising foreclosures and falling housing prices
reinforce each other.

It’s no secret the housing market is dragging down the
economy. Weak housing prices are hampering construction, which
typically powers post-recession recoveries, and making consumers
feel too poor to spend. Much of the problem stems from
foreclosures, which continue to drag down home prices. New data
this week showed that as of December, prices in 20 U.S. cities
stood at their lowest since the housing crisis began.

Fannie and Freddie, which own or guarantee 60 percent of
outstanding mortgages, are a critical part of any solution.
Their loans account for about 3 million of the estimated 11
million mortgages that are “underwater,” meaning the borrowers
owe more than the homes are worth and are hence prime candidates
for foreclosure. To support strapped homeowners, Fannie and
Freddie are refinancing loans and offering “principal
forbearance,” in which principal payments are temporarily
deferred. Helpful as those efforts are, they clearly are not
enough.

The Obama administration agrees and has called on FHFA,
which oversees Fannie and Freddie, to allow the mortgage giants
to cut the principal balance for borrowers in danger of
foreclosure. To make it worth their while, the Treasury recently
offered to pay Fannie and Freddie as much as 63 cents for each
dollar of principal that is forgiven.

DeMarco has so far rebuffed calls for principal reduction,
saying it is difficult to do and violates his mandate to protect
taxpayers against losses at Fannie and Freddie. Although his
motives are commendable, we think he’s wrong. Fannie and Freddie
can offer principal reductions in a cost-effective way that
helps the companies minimize losses and may actually improve
their financial condition down the road. The solution is a
shared appreciation model, in which Fannie and Freddie agree to
forgive a certain portion of a borrower’s debt in exchange for
sharing in any future increase in the home’s value.

The idea is already being employed with some success by
private-sector mortgage servicers like Ocwen Financial (OCN) Corp.,
which has used shared appreciation principal reductions in more
than 20 percent of its mortgage modifications, or about 9,000
loans. The result so far is encouraging: Ocwen’s redefault rate
on principal reductions is about 8 percent, far lower than the
20 percent industry average for other types of mortgage
modifications, such as refinancing.

Here’s how such a program would work. The lender cuts the
borrower’s outstanding balance, generally to 95 percent of the
current market value of the home -- a move that reduces the
monthly payments, restores equity and provides a renewed
incentive to maintain the home in good condition. The written-
down portion is set aside in a non-interest-bearing account,
which is forgiven over a three-year period as long as the
homeowner makes monthly payments. In exchange, the homeowner
agrees to give up a portion -- typically 25 percent -- of any
appreciation in the home’s value. The debt relief requires
lenders to take an immediate loss, but they tend to fare better
financially than if the home went into foreclosure, and they
benefit once the housing market recovers.

Incomprehensibly, DeMarco told lawmakers that FHFA does not
need to consider such an approach because it is essentially
performing shared appreciation reductions through its
forbearance program. He also points to FHFA analyses that show
forbearance to be slightly less costly than forgiveness for
cases in which all underwater borrowers get modifications. The
difference -- about $300 million on $300 billion in loans -- is
far too small for certainty. More important, it ignores the
upside that a shared appreciation program would provide.

By requiring borrowers to give up a portion of what is most
Americans’ largest investment, shared appreciation also
mitigates the biggest knocks against principal reduction: that
the prospect of debt forgiveness could encourage more homeowners
to default, and that it rewards people for taking on too much
debt. Some of that will still happen, but those unavoidable
downsides do not outweigh the need for a stronger housing
market, which will benefit all Americans by boosting the U.S.
economy.